Making Financial Regulations Work for Society

Comments by Anat Admati
Finance and Society Conference, May 6, 2015

I am thrilled to be here with Brooksley Born, one of our great heroes of financial regulation. This event culminates work of about two years. I am grateful to co-organizers Gudrun Johnsen, Signe Krogsrup, and Ceyla Pazarbasioglu, for sharing the passion, and to Rob Johnson and all the folks at the Institute for joining us and putting so much work and resources into making the conference come together in this amazing way. I also want to thank other sponsors, especially Stanford GSB, my professional home for more than 30 years. Finally I am grateful to the wonderful speakers, and to all of you, for engaging on the issues.

I am a Finance academic. Before the financial crisis, I did research on financial markets and contracts, most recently on corporate governance. I taught finance to future managers and entrepreneurs. Before immersing in the technical details of valuing stocks, bonds, derivatives and companies, I always told my students that the financial system is really useful for society because it helps move money across time, allocate risks, and fund productive investments.

My life changed starting at the end of 2008. Fortunately for me, I didn’t lose my job or my house. I still do research in finance, currently on the forces that shape corporate funding decisions and how they can lead to excessive use of debt and great inefficiencies. But I am no longer in the silo I occupied and I talk to many more people both in other academic fields and outside academia. I teach a course entitled, like this conference, Finance and Society, which draws from multiple fields, including finance, economics, accounting, law, and political science. Even psychology, philosophy and sociology can bring insights.

What changed my life was seeing bad research and false or misleading claims, including from academics, affecting policy. Innocent people, powerless and often ignorant of the issues, are harmed by bad policies.

I assumed that at least academics and policymakers would welcome engagement so we can get the policy right, but I was wrong. People don’t want to engage when what you say challenges their viewpoint or actions. They ignore and evade. I’ve witnessed not only blind spots, but what Margaret Heffernan writes about, willful blindness.

I had to step out of my silo and question my assumptions to understand better what is going on. I urge you to do the same. You can’t understand Finance and Society from any one silo.

Governance problems — when someone has control over decisions while others are impacted but don’t have enough control — are everywhere. If people can benefit at the expense of others, without facing any negative consequences, they often do just that. If people find it convenient to say false or misleading things (which they might even believe to be true) without being challenged, they often do that. If people can stay silent even if they know harm is done, they often do that, especially when staying silent pays and speaking up is personally inconvenient or worse.

These issues are not unique to finance. Pursuing profits in free markets may cause people to lie, pollute, or sell unsafe products. GM knowingly sold cars with a faulty ignition switch. Tobacco companies knew but denied for decades that smoking is addictive and harmful. The makers of an unsafe portable crib that was recalled after killing 3 babies failed to actively alert parents to the safety problem, and in fact tried to prevent people from finding out that the crib was unsafe, which resulted in the death of my friends’ 16 month old son in 1998 and at least 18 additional babies.

So in our free markets, people might carelessly play with “other people’s lives, other people’s babies” if they can get away with it. We get relatively safe air travel in part be cause crashed planes are on TV for all to see, and we relate to the harm, and because accountability can typically be established. Airlines, engineers or others can’t spin that the plane crashed because of an unforeseen lightening, or that it was “a perfect storm.”

The financial system is not serving society well right now, certainly not as well as it can. It is a drag on the economy. Finance is fraught with governance problems. Free markets don’t solve these problems. Effective laws and regulation are essential.

The governance problems, however, go all the way to the politics. That’s why today’s first panel about “other people’s money” went beyond the culture of financial firms into the political issues around regulations. Improving the regulations, and sometimes the law, as well as their enforcement, is the key to a better system.

We heard this morning from Fed chair Janet Yellen that there is recognition of the issues and progress on improving regulation. The massively complex Dodd Frank Act was signed hurriedly into US law in July 2010. Almost five years later, the debate about the law is highly political. Some say that, even if it is imperfect, every part of the law must be protected at all costs. Others want to dismantle it altogether.

There are numbing details to all these regulations, here and elsewhere. You’ll hear about Basel rules, macroprudential regulations, ring fencing, etc. A short appropriate summary of the regulatory reform effort is an unfocused, complex mess, both in design and in implementation. Some regulations end up as wasteful charades. They provide full employment and revolving opportunities for numerous lawyers, consultants, and regulators without producing enough benefits for society to justify the costs. Some of the complaints from the industry about these regulations have merit. In this category I put living wills, stress tests, risk weights, TLACs/cocos/bailinable debt (whatever the term for today), and liquidity coverage ratio. I am also concerned that, as implemented, central clearing of derivatives does not reduce, and may even increase, the concentration of dangerous risk. In all these contexts we see the pretense of action, the illusion of “science,”afalse sense of safety, over-optimistic assessments of progress, and counterproductive distortions.

Lost in this mess are simpler, more straightforward regulations that would counter the incentives for recklessness and bring enormous benefits to society by making the system safer and healthier, as well as reducing unnecessary, unproductive risk that is a key source of system fragility, and the many distortions. I don’t think trying to reinstate Glass Steagall should be a top priority even if it may have some merit. Another bipartisan proposal by Senators Sherrod Brown and David Vitter offers more immediate “bang for the buck” and has a better chance, if implemented properly, of helping even on its own.

Among what’s most wrong with the financial system and most essential (and possible) to correct is that, even with new rules so far, there is still too much opacity and hidden risk and too much reliance on debt funding. There is no justification for this situation. Yet, an enormous amount of nonsense has tricked policymakers into tolerating it.

After six years of discussing these issues with many and writing to explain, I am very disappointed to see that so much nonsense continues to be uttered and to impact the debate. It might take another harmful crisis, or more, to make progress. What we are tricked into tolerating, even subsidizing, is the equivalent of allowing trucks full of dangerous chemicals to drive at 120 mph in residential neighborhoods (and having trouble actually measuring actual speed), which burns lots of fuel, harms the engine and risks explosions. We rush to do whatever it takes to fix the trucks should they implode, since they deliver essential fuel. We may even give the drivers, safely ejected, jobs as policemen during repairs… Lower speed limits, we are told, will “harm growth” or send deliveries to a “shadow trucking system” around the corner that, for some reason, we can’t send the cops to patrol.

Making the system more transparent and dramatically reducing the reliance on debt would be hugely beneficial. All claims against this approach are nonsense, spin and flawed excuses. Among the benefits, it will improve, stabilize and correct distortions in credit markets, and reduce the incidence and intensity of boom and bust cycles and costly crises that bring prolonged recessions. It will make the governance problem of financial institutions more contained and manageable, more similar to that of other corporations. Tying back to Signe’s opening remarks, it will even help central banks “transmit” their policies to the rest of the economy. A sick financial system doesn’t do the job, and thus harms recovery and growth.

There are many challenges in the details of the regulations, especially around measurement issues, but the challenges can be met. Frustratingly, regulators are spending enormous resources on all these more complicated and less cost effective efforts mentioned above, and neglect the best bargains in regulation. Indeed, another bonus of taking strong actions to reduce opacity and reliance on debt would be to make these complex other measures discussed above, LCR, TLACs, living wills, etc less relevant, less important, and less costly.

We also make life harder for ourselves by keeping counterproductive laws that create more of a conflict between what is good for those in financial firms and what is good for the rest of society. These include, as Senator Warren mentioned, a bad tax code that perversely encourages the use of debt and punishes equity funding for corporations (and sometimes for households too). And our bankruptcy code gives special, superior status to counterparties of certain financial contracts, perversely enabling and rewarding reckless practices that harm. These laws are not in the bible. They can be changed.

Why all this nonsense and bad policy? First, harm from finance is abstract and spread out. Connecting the harm to individual wrongdoing or recklessness is hard to establish. Courts might work for fraud, but you can’t take someone to court for designing bad regulations. Second, the jargon of finance is impenetrable, and those in and around the industry, and often the regulators too, want to make it all sound really complicated, which helps them dismiss and evade. Third, everyone, especially politicians, loves credit and wants to tell financial institutions where to put their money. Most people, especially most politicians, want to stay on good terms with the rich people who run financial institutions.

Finance is about money and power. Money and power can corrupt. So unlike in the airline business, in finance it is possible for the industry, regulators and politicians, to harm and endanger, to spin narratives and cover up the harm, and to be willfully blind, without any accountability. DoJ and the SEC must do their job, but they can’t deal with nonsense and capture.

So the biggest challenge in regulation is political. The details hardly matter if there is no political will. Unfortunately, most politicians put other objectives ahead of having a stable and healthy financial system. Ordinary people, meanwhile, may not be aware of what is going on or get confused by the spin. Not enough people understand why regulation is essential and what type of regulation makes sense.

What can be done? Here are some concrete ideas. First, increasing the pay of regulators may reduce revolving door incentives. Second, effective regulators might be industry veterans who are not inclined to go back. Third, we must try to reduce the role of money in politics.

Of course, there are some amazing people involved in the effort for financial reform, including politicians and regulators. These people have the political will, they do engage, they do remember what it’s about. A number of these role models are on the program for this conference, and there are many more in the room and elsewhere. For example, with us today is Tom Hoenig from FDIC, who is one of my heroes and should be one of yours.

Unfortunately, there are too few of them. We must thank these individuals. Goldman Sachs’ CEO was wrong when he said banking is “God’s work.” Creating and enforcing good financial regulation is God’s work. The forces on the other side are depressingly powerful and it would be tempting to get discouraged and give up.

Those of us who are not policymakers must also do what we can to help. We must engage, question our own assumptions (and not believe everything “experts” say), applaud progress, protest setbacks, challenge the narratives and expose the nonsense.

Badly regulated financial system and counterproductive laws do great harm to society. The spin allows them to persist.

Remarks of Brooksley BornFinance and Society Conference, May 6, 2015

I am delighted to participate in this conference on Finance and Society, particularly because some of the other participants are women who have made a real difference in the oversight and regulation of the financial sector, which is still male-dominated. They have faced and overcome special challenges in their careers, and their achievements are especially notable.

A major issue facing the country today is whether we can structure a regulatory regime for our modern financial markets that adequately protects the financial system, the economy and the American people. Enactment of the Dodd Frank Act in 2010 was certainly a good first step toward doing so and the most significant financial regulatory reform since the Great Depression. However, despite the passage of almost five years, the jury is still out on whether Dodd Frank will be fully implemented and rigorously enforced. Also, it may well be that Dodd Frank did not go far enough to protect against another devastating financial crisis.

Why is fashioning this regulatory regime so important? The 2008 financial crisis demonstrated the catastrophic results of inadequate business regulation in the financial sector. As documented in the report issued by the Financial Crisis Inquiry Commission on which I served, decades of deregulation and failure to regulate newly emerging financial markets, firms and products led to a financial system that was extremely fragile and vulnerable to a full blown crisis when the U.S. housing bubble collapsed in 2007 and 2008. The financial sector had poured billions of dollars into convincing federal policymakers of the need for such deregulation, supported by the fallacious beliefs— championed notably by Alan Greenspan—that financial markets are self- regulating and that financial firms are able to police themselves. As found by the FCIC, the resulting failures in financial regulation and supervision, along with failures of corporate governance and risk management at major financial firms, were the prime causes of the crisis.

I am concerned that the political and financial power of our largest financial institutions continues to be an obstacle to effective regulatory reform. Some of these firms are larger and control more resources than ever because of mergers and concentration resulting from the crisis. The financial sector continues to be the largest source of federal campaign contributions and reportedly fielded five lobbyists per member of Congress during its Dodd Frank deliberations. As Senator Dick Durbin of Illinois said at that time, “[T]he banks … are still the most powerful lobby on Capitol Hill. And they frankly own the place.” (Huffington Post, Dick Durbin: Banks “Frankly Own the Place”, 5/30/09.) They used their political power to weaken, eliminate or create exceptions to many provisions of Dodd Frank.

The esoteric and complex nature of the markets, products and institutions makes it difficult for policymakers and the public to fully appreciate and understand the need for and likely impact and implications of various types of regulation. And of course, the financial sector’s officials, lobbyists, lawyers, economists, accountants and public relations firms dominate the discussion of these issues.

Since Dodd Frank’s enactment, financial services firms have continued to resist effective reform, pouring enormous resources into challenging agency action implementing its provisions by delaying the issuance of regulations, watering down the terms of the regulations issued and contesting regulations in court. It is no wonder that after five years some important regulations under the Act have not yet been adopted, let alone implemented and enforced.

And the statute itself may be in danger. In December one or more of our largest banks used political power to get Congress to adopt a repeal of the derivatives push-out provision of the Act, a provision designed to protect against risky derivatives transactions by banks with government-insured deposits. Many fear this is the first step in a broad- based industry effort to repeal important protections of the Act.

The power and influence of the financial sector threatens a continuation of the regulatory capture that contributed to the financial crisis. Financial firms too often have significant say in the appointment of high federal regulatory officials. The tendency of some former federal officials to obtain highly lucrative positions in the financial sector after leaving government may well act as an inducement to those remaining in government to serve the interests of the financial sector rather than the public. Moreover, financial sector pressure has restricted the amount of appropriations for the SEC and the CFTC and thus limited the agencies’ ability to exercise their new regulatory powers.

Furthermore, there has been little accountability imposed on the firms, their executives and their boards of directors in the wake of the financial crisis. The crisis was caused in large part by reckless behavior and significant failures in corporate governance by our largest financial institutions. A number of them were bailed out with government funds with limited repercussions for their management. The crisis also involved what may have been the most pervasive investor fraud in history in the sale of mortgage-backed securities and CDOs without adequate disclosure of the poor quality of the underlying mortgages. While civil penalties have been imposed on some firms, there have been virtually no criminal prosecutions of institutions, and responsible officers and employees have faced few prosecutions or civil penalties. Investors, homeowners and taxpayers have been left to bear the major brunt of the financial crisis.

It is clear that the problems with the financial sector are not behind us. Since the enactment of Dodd Frank, we have seen many egregious examples of fraud, manipulation and other illegal or reckless behavior on the part of financial institutions. They have been involved in significant price manipulations of interest rates and foreign exchange markets. We have recently learned of allegations that high frequency trading in S&P futures was used to manipulate the securities markets during the 2010 flash crash. Large financial institutions have been involved in significant cases of currency fraud and aiding money laundering and tax evasion. With respect to derivatives trading, JP Morgan lost $6 billion through the speculative trading of the London whale, and both MF Global and Peregrine Financial went bankrupt after allegedly engaging in misappropriation of customer funds.

In light of all this, we must ask ourselves whether the financial and political power of our largest financial institutions poses a threat to policy making on financial regulation and seriously undercuts the administration of justice. In my view, these institutions continue to be too big and interconnected to be allowed to fail without serious repercussions for the financial system and the economy as a whole, despite provisions in Dodd Frank meant to alleviate this problem. They are also arguably too large and complex to be susceptible to meaningful management, supervision or regulation.

Let me comment briefly on the current state of regulation of the over-the-counter or OTC derivatives market. Dodd Frank gave the Commodity Futures Trading Commission an enormous new responsibility to impose regulation on this previously unregulated market, which is currently estimated to be $400 trillion in notional amount in the US and almost $700 trillion globally. The CFTC has performed a Herculean task in finalizing more than 50 new rules required by the Act. It still has some significant work to do, including establishing position limits, as well as fully implementing and enforcing the rules already adopted.

The jury is still out on whether the regulatory regime under Dodd Frank will be adequate to address the dangers of this market, which contributed significantly to the financial crisis by helping to fuel the housing bubble and amplifying and spreading the losses when the bubble collapsed. The Act provides for centralized clearing by regulated clearing operations, thus reducing counterparty credit risk such as that caused by AIG’s threatened default during the financial crisis. It also provides for trading of cleared derivatives on regulated exchanges or swaps execution facilities, which should provide essential price discovery and government oversight for fraud and manipulation.

However, because Dodd Frank expressly provides for some significant exemptions from clearing and exchange trading, a substantial portion of the market will likely remain over-the-counter. For example, under authority in the Act, the Secretary of the Treasury exempted foreign exchange swaps from Dodd Frank requirements. As I noted earlier, since that exemption was adopted, there have been revelations of massive price manipulation and fraud in that market. In addition, swaps transactions by commercial entities for hedging purposes are expressly exempt from clearing and exchange trading, and indeed such entities will not even be required to post margin on their uncleared transactions. So a significant portion of the US market will not have the very important protections of central clearing, exchange trading and margin requirements.

New rules under Dodd Frank governing this remaining OTC market are intended to reduce its risks. OTC derivatives dealers will have to meet minimum capital and collateral requirements and will be subject to business conduct rules. Swap data repositories will facilitate transparency and government surveillance, and the Act forbids fraud, manipulation and excessive speculation. Whether the continuing OTC market will be adequately regulated under this new regime remains to be seen.

The OTC derivatives market is a truly global market, and many of the firms involved in the market have worldwide operations. While there has been international consensus that central clearing and exchange trading are essential to protect the financial system, most other countries have not yet adopted laws implementing those requirements. It is essential for the US to work closely with other sovereign states to ensure the cooperation, coordination and harmonization needed for effective oversight of this global market.

While the task is not easy, it is imperative that we keep working on improving and implementing our regulatory regime. We must muster the political will to do so in order to try to mitigate the impact of future financial crises. The American public deserves no less.